Musings on economics and politics, with a special interest in free banking and monetary disequilibrium.

Sunday, November 30, 2014

Kaminskia on Free Banking

Izabella Kaminska wrote a defense of the Bank of England on her blog at the Financial Times . It was apparently motivated by the new "positive money" proposal to fully separate money from debt and banking along with those who would like to see bitcoins replace fiat currency. (I am pretty dismissive of both of those groups as well, and might defend central banking against them, despite my free banking sympathies.)

However, she made a passing criticism of free banking:

As an aside, it’s worth pointing out that the Scottish period of free banking that preceded the great inflation — often touted by free-banking enthusiasts as an excellent example of how the free-banking model is inherently stable — revealed how cartels and monopolies could be used to stabilise the currency. In fact, it was only because the Scottish banks were so good at forging oligopolistic cartels that happily restricted competition that the Scottish free-banking period proved so stable in the first place (defeating the pro free-banking argument altogether).

The link is to a blog called "SOCIAL DEMOCRACY FOR THE 21ST CENTURY: A POST KEYNESIAN PERSPECTIVE," which is not a title that generates much credibility with me. Worse, when you try to find out the author of the blog, there is nothing.

However, the linked post at least cites Goodhart (1987,) which seriously critiqued free banking on a theoretical level. Most of the rest of the post was pretty weak The various episodes described as "free banking" were shown to have included at least some some government regulation of banking.

George Selgin responded to Kaminska in the comments, and I thought he was much too harsh. I admit that this is the frying pan calling the kettle black and that I am suggesting that Seglin do as I say and not as I do, but at first pass, playing the role of the patient professor might have been a better place to start.

Still, I agree with Selgin that Kaminska's version of 19th century British monetary history was more than a bit skewed. She certainly seemed to suggest that Peel's Act was a necessary corrective to inflation caused by the uncontrolled issue of paper currency by "country" banks in England. Of course, it also spelled the end of the Scottish system of private note issue as well. But really? Does anyone think that Peel's Act was necessary or even sensible? 100% marginal reserve requirements for hand-to-hand currency? Why?

Kaminska appeared to have replied to Selgin on her blog--Dizzynomics. She didn't refer to him by name, and if Selgin's comment on her original article was too harsh, her reply was absurd Free banking advocates (Selgin?) seem to be "reason and logic deniers." Apparently, the key element of reason and logic they deny is:

But the main issue I have with them is that they appear to have no understanding or appreciation of the cyclicality of systems or the fact that whenever we’ve had free-banking systems they’ve resulted in chaos or alternatively co-beneficial collusion to the point the system is not free by the standard definition of free.

I don't think the "cyclicality of systems," is a principle of reason or logic. The claim about "chaos" is hyperbole at best.

Kaminska writes on in a way that suggests that "free banking" means the monetary institutions of anarcho-capitalism. Since many of the leading lights of "free banking" lean in that direction, and even more so those they have influenced, I can imagine that one can find people who will argue that all potential bank misbehavior can be handled by private arbitration. While that may or may not be true, what I count as "free banking" hardly requires that the banking industry be singled out for fully-privatized law enforcement.

Perhaps more interesting is her claim that more-or-less successful free banking systems are not truly "free" but rather instances of collusive oligopoly.

Unlike many, if not most, free bankers, I see free banking as a series of reforms rather than conceiving of a banking system without any government intervention.

One key reform, and one that superficially seems radical, is the private issue of redeemable hand-to-hand currency. In my view, redeemability is pretty much all that is necessary to keep a competitive banking system in line. By that I mean,each bank's market share in the issue of currency will reflect the preferences of those using the currency and the total amount of currency issued will reflect the preferences of the public to use currency relative to deposits.

Now, this constraint works though a clearing system. And while there have been private clearinghouses that have handled the task quite well, this particular reform is consistent with having a central bank handle the clearing system--like the Federal Reserve. The way I see it, whether or not it is desirable to privatize the clearing system or leave it in the hands of a government-run "bank" is a separate question from whether or not redeemable privately-issued hand-to-hand currency creates special problems.

A second reform, which I had thought was no longer controversial, is branch versus unit banking. In the U.S., there were many regulations aimed at protecting unit banks. These would be single office banks. To bring it back to Kaminska's history, some of the regulations of the "country banks" in 19th century England were aimed at keeping them small. One strength of some of the "free banking" systems, including both Scotland and Canada, was widespread branching.

The key reason why branch banking is superior to unit banking is geographical diversification. To the degree that a unit bank receives deposits locally and makes local loans, when the local economy is troubled, the bank will have trouble collecting on loans exactly when its depositors are in need of their funds. In the U.S., a key rationale for deposit insurance was to overcome this weakness.

However, the branch banking system does make private currency more feasible. While thousands of unit banks might each issue private currency, and the currencies might each do just fine in their local community, the experience of the U.S. "free banking" era suggests that that they were less than suitable for a national currency.

But really, unit banking was not all that suitable for promoting a payments system by check either. And so a system of banks,each with extensive branching, not only provides geographical diversification, it also allows both privately-issued hand-to-hand currency and checkable deposits to form a national payments system.

Now, is a nationally branched system an "oligopoly?" In fact, the unit banking system was more about protecting local monopoly than creating competition by having a large number of banks. In practice,a system made up of a smaller number of banks, able to open and close branches in various localities, has proven more competitive than a system of many small banks each tied to a particular locality.

Would a U.S. banking structure of 20 large banks all with branches nearly everywhere be "oligopolistic?" Well, I suppose it doesn't meet the neo-classical definition of perfect competition. But that is hardly a reasonable standard for real world competition.

There are more reforms that are associated with free banking. Some are no-brainers like ending reserve requirements or allowing free entry. Others are much more challenging, like ending deposit insurance and capital requirements. But rather than treat them separately, I will focus on what I consider the point where the "oligopoly" and "collusion" charge is most likely to stick, and that is the clearinghouse.

This points to Goodhart's criticism of free banking. Consider a clearinghouse organized as a private club. (Say each bank owning stock in the clearinghouse in proportion to capital?) For the payments system to work well for the nonbanking public, each bank needs to accept banknotes and checks drawn on other banks at par, depositing them at the clearinghouse, cancelling offsetting claims, and settling up net clearing balances.

To start with, by accepting each other's items for deposit at par, the members of the clearinghouse serve as creditors to each other. Goodhart, following Timberlake's study of U.S. practice in the 19th century, argues that the clearinghouse serves as lender of last resort. This expands the club's role as creditor. It is important that the clearinghouse have information about its members in order to determine if they are good credit risks, but since the member banks are all competing with one another, they will not want to share that information. QED, the Bank of England should exist.

Since Goodhart's argument was closely tied to arguments about banks being subject to runs, I didn't find it convincing The solution to runs is an option clause. They were banned long ago, because governments understood that it served as an alternative to holding reserves. Encouraging banks to hold (gold) reserves was a key policy goal at the time.

Still, limiting membership to the clearinghouse would be an obvious mechanism to provide for a barrier to entry. That each member is a creditor to the others provides a plausible rationale. Perhaps membership could be limited to "sound" banks as proved by their unwillingness to pay more than a "fair" interest rate on deposits or charge less than a "fair" interest rate on loans?

All this shows is that in a world without anti-trust, a clearinghouse association could be an avenue for collusion. But we live in a world with anti-trust, so abuse of clearinghouse rules to organize and enforce a bank cartel would be illegal. Unless, of course, free banking is taken to mean that the banking industry must be singled out for an exemption to anti-trust law.

However, I do think there is something very special about the clearinghouse. It is what turns a variety of financial instruments into a medium of exchange. Of course, it isn't exactly homogeneous, but retailers typically accept payments by check or electronic equivalent and deposit the funds in their own banks. Banknotes, privately-issued hand-to-hand currency, can smoothly fit into the system.

The clearing system is very effective in limiting each bank to a market share determined by the preferences of depositors. The same should be true of banknotes, even though it has been many years since redeemable banknotes have had much circulation. The problem is that the aggregate quantity of money of all types is limited to the demand to hold money by some kind of response to macroeconomic disequilibrium. This response is closely tied to the determination of the nominal anchor for the system.

Historical free banking systems were small open economies with monetary liabilities tied to gold--an international money. As repeated by the anonymous Post-Keynesian cited by Kaminska, Goodhart's point that much of the redeemability by these free banking systems were with credit instruments drawn on a major money center should be no surprise. What other routine calls for redemption would exist other than a demand for foreign exchange? And while the quantity of those securities/reserves would not be fixed, neither would the quantity of bars or even gold coins from the point of view of the banking system of a small open economy in a gold standard world.

What we think of as monetary theory these days would best apply to the entire portion of the world using the gold standard. The price level depends on the supply and demand for gold. While gold strikes might be inflationary, the major source of macroeconomic disruption would be shifts in the demand for gold. It really doesn't matter if it is due to finance or fashion. A shortage of gold requires a higher relative price for gold and so a lower price level. Until prices and wages adjust, real output will be depressed. Further, it is hard to see how liquidating debts based upon higher expectations of nominal income can be anything but disruptive and painful. The notion that by having a "free banking system," some portion of the gold standard world could be insulated from these problems is implausible.

According to the wiki for free banking, cited by the anonymous post-Keynesian, an alternative to a free banking system tied to gold is one tied to a fixed quantity of fiat currency. Selgin, in his Theory of Free Banking, describes such a scenario. While I think the market process he describes, where nominal income tends to be stabilized, is instructive, there is something very problematic about a system where the nominal anchor depends entirely upon the demand for an asset solely held by members of a private club--the clearinghouse. Changes in the settlement rules at the clearinghouse could have a major impact on macroeconomic conditions.

Greenfield and Yeager's Black-Fama-Hall payments system was a type of free banking. The constraint on the banking system was indirect convertibility. I always argued that indirect convertibility would have its primary impact at the clearinghouse--as a practical matter, no one else would have any reason to do anything other than spend money. In fact, I have always thought that a rule requiring indirect convertibility at the clearinghouse would be sufficient to constrain the banking system.

Practical considerations eventually convinced most of us thinking about this sort of system that indirect convertibility would need to involve some kind of index futures contract. While Greenfield and Yeager aimed at stabilizing the price level, and Kevin Dowd has continued to promote free banking tied to that nominal anchor, I think slow steady growth of nominal income (NGDP) is a better approach. Index futures convertibility provides tremendous flexibility regarding the nominal anchor.

I certainly don't think that having the nominal anchor determined by a private club of banks is a sensible monetary regime, no more than giving clearinghouses the right to vary the price of gold would have been sensible in a historical free banking system. And that is where I think free banking theory is today. What rules should be imposed on the clearing system to keep the total quantity of money created by the banking system consistent with the nominal anchor?

And to bring this back to Kaminska, the anonymous Post-Keynesian, and Goodhart, at some fundamental level, I grant that a desirable free banking order will require a clearinghouse with appropriate rules. Collusion? Well, I don't think that such rules should be anti-competitive, but they certainly involve constraining the banking system--what might broadly be described as regulation.

As for the historical record--I don't think that the free banking portions of the world were especially chaotic or the source of instability under the gold standard. And the actual behavior of both the proto and actual central banks of the gold standard era most certainly caused massive macroeconomic disruption.

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